Are ETFs or Mutual Funds Better For a Roth IRA Account?

I recently received an e-mail concerning whether one should invest in ETFs or mutual funds in a Roth IRA account.

Here’s the entire question:

Hi TJP, In your article "Will the International Real Estate Bull Market Hold Up?" (23-May-07), you mentioned the DJ Wilshire Intl Real Estate (RWX) for quick international REIT diversification. According to your subsequent blog, you picked the Alpine International Real Estate Equity fund [EGLRX] for your Roth IRA. Why didn’t you pick ETFs, such as RWX or the new WISDOMTREE TRUST (DRW), for lower costs in a long term account, such as an Roth IRA? I am torn what to pick for my Roth for lower costs over time.

So how do we figure out which method of investing performs better? We calculate the numbers, and let math be the deciding factor!

Using my Fidelity Investments account (where I own my Roth IRA) as an example, I will backup my preference for actively managed mutual funds over passive ETFs when investing in the international real estate market. Of course, my reasoning may change in the future.

Your Choice - Lower fund expense ratios or 18 Years of International Real Estate Experience?

As the reader pointed out, I invest in Alpine’s International Real Estate Fund [EGLRX] in my Roth IRA account instead of passive ETFs like SPDR DJ Wilshire Intl Real Estate (RWX) or WISDOMTREE INTL REAL ESTATE (DRW).

You are probably thinking that ETFs perform better over the long term due to their lower expense ratios. So let’s compare the expense ratios of all 3 funds, then see how they would perform over the long run (assuming the fees remain the same).

First off, the longevity of Alpine Investments Real Estate Fund & fund manager Samuel Lieber indicates a certain level of stability and safety when investing in EGLRX. I would never invest in any fund that has a fund life of 1 year of less. Investing in RWX or DRW requires an audacious step because we have very little past fund history to examine and research.

While you pay twice as much to invest in EGLRX, consider this opportunity cost because you gain access to a top notch fund manager with over 18 years of experience in international real estate.

Is 18 years of financial experience in international real estate worth an extra 0.6% in expenses per year?

To me, it’s worth the extra cost since the fund needs to outperform the tracking ETFs by only 0.6% to make up the difference. EGLRX returned 16% over the past 10 years, crushing DJ Wilshire REIT index (its underlying index) by over 15%.

Comparing Fund Costs with Vanguard’s Costs Tool

Let’s see how much the extra costs will effect an initial $10,000 over the course of 20 years assuming a 10% annual return. Vanguard has a nifty fund costs tool that performs the job nicely.

While ETFs appear to perform better over the long term, these numbers assume a few factors like:

Apline Real Estate Fund will match the returns of RWX & DRW - Sam Lieber’s fund could outperform the alternative ETFs in the long run. One reason is that Apline investors gain exposure solely to Sam Lieber’s picks, however ETFs expose investors to the entire international real estate market. I don’t want to own everything; I only want the good stuff.

Fees do not increase between any of the 3 funds - An expense ratio increase could rain on all your long term investment plans.

You never sell your ETFs - By selling your ETFs, you have to pay out a sales commission. Normally, investors can buy/sell mutual funds at no cost if you trade with a top notch broker.

Deciding between No Cost Mutual Fund Buys or Commission-based ETFs

All the data above assumes you pay zero commission fees, but the average broker charges commissions on Stocks/ETF trades. Unless you have an account with a broker like Zecco who offers free stock/ETFs trades, ETFs commissions will eat up a portion of your returns.

As for mutual fund trades, many brokers like Fidelity provide free trades when you setup an automatic account builder plan, but ETF trades cost $20 per transaction.

Other differences between ETFs and mutual funds include price sensitivity, tax implications, etc.

Investing is very personal in nature - there is no right answer

Being a college student, I have limited funds, and choose mutual funds over ETFs to avoid commission fees. My financial situation is probably different from yours, so your investment strategy will differ as well.

If you believe in strictly passive investing, then invest in exchange-traded funds instead. Just make sure you control unnecessary commission fees, and understand which investments your ETFs hold.

Now’s your chance to share your insight on ETFs and mutual funds for long term retirement accounts.

Comments

[d_teller:]

Interesting perspective. Re Fido's trading of open-ended mutula funds: the No_Fee status of a fund can disappear. ADVDX (Alpine) was an NTF last year, but not now. It would cost $75.00 to purchase or sell right now. On the other hand, FIREX (Fido's Intl RE fund) doesn't have a charge, but its history is relatively short, and NAV's been declining, because global interest rates are rising.

Regarding Investing for the long-term in a Roth IRA, one needs to look at a long-term trend of a sector, before putting $ in a lump.

One big problem with OEM's, is they pay CG & Divs, when their NAV'S have risen, and if one reinvests at that point, you're buying high. From 2000 to recently, REIT valuations have risen (out performing the broad S&P), because money was cheap, borrowing costs were low, and inflation seemed to be a diffuse, periodic threat. That's now changing. If you want dividends to grow your Roth's valuation, you may only see 2-4% for domestic REITS vs the 5-7% extant in the beginning of this decade.

There are some companies in the REIT arena that pay better, (and they're not weeny caps) : Thornberg Mortgage (TMA) pays about 10% (buy it below 26.00); AINV (Apollo Investment) is a business development Co. with ca. a 9 % yield and it's got a long and successful history. They buy and sell companies, but unlike some private equity and partnerships, they have structured to pass through some 70% of their earnings. The field is enormous, and if one has access to Thomas White, Lehman or Yahoo, one can look at the comparison ranking of the subsector of the REITs. One can also access general info (the category of the REIT) at NAREIT.com.

When interest rates rise above 6% on the 10 yr Treasury, REIT valuations will probably be lower for the Mall, Office and even Apt. Real estate subsectors. I've had REITs in my IRA's for 30 years: sold some in March for astronomical gains (more than 10 yrs of expected dividends), but only certain Health Care/Medical office owners seem to be maintaining the prices of this winter.

In summary, I wouldn't buy a CEF or ETF in real estate now. I might purchase an individual security (stock) in a subsector.

2007 Jun 19 05:24 PM